Many firms, companies, corporations, and other entities issue securities such as straight debt or common stock in order to raise capital for their business endeavors. A straight debt security (e.g., a bond, a note, a loan, or a mortgage) raises capital by arranging for an entity to repay a principal amount of borrowed debt, and interest on that debt, throughout the life of the security. A common stock security raises capital by selling an equity interest in the entity. Entities may also sell convertible securities, which provide their holders with the option to exchange the convertible securities for other securities (e.g., common stock) at a predetermined conversion price.
Convertible securities are attractive to investors due to their capacity for earning interest like a bond when the common stock price is below the conversion price, while realizing value like common stock when the stock price rises. This occurs because typically the holder of a convertible security has the option (but not the obligation) to exercise the conversion feature at a time of the holder's choosing. The value of this option is derived from its terms and from the characteristics of the underlying security into which the convertible security is convertible. Often the option's value is sufficient incentive for an investor to accept a lower interest rate on the convertible security than might normally be acceptable to the investor for non-convertible securities. However, because the option derives much of its value from the value of the underlying security, adverse changes in the characteristics of the underlying security can significantly reduce the option's value. The possibility of such changes reduces the value investors initially ascribe to the option and therefore reduces the interest rate savings for the issuing entity compared to issuing straight debt.
For convertible securities, where the underlying security is generally common stock of the issuing entity, events and situations that adversely change the characteristics of the underlying security often revolve around changes of control of the issuing entity. These can include, for example, acquisitions, mergers, takeovers, exchange offers, liquidations, combinations, reclassifications, recapitalizations, consolidations or similar transactions (the foregoing being examples of “fundamental changes”). Historically, convertible securities address these events by providing that the investor's option to convert into the underlying security is automatically changed to an option to convert into whatever the investor would have received as a holder of the underlying security if the investor had exercised the conversion option immediately prior to the event. For instance, if in the course of a merger the common stock of the target was purchased by the acquirer for $100 per share, a convertible security issued by the target that was convertible into 10 shares of the target's common stock would become convertible instead into $1,000 ($100 multiplied by 10 shares). If the acquirer had instead paid 5 shares of its common stock per share of the target's stock, the convertible security would become convertible into 50 shares of the acquirer's stock (5 acquirer shares multiplied by 10 target shares). The new assets/consideration into which the original underlying security may be converted, will for convenience continue to be referred to herein as the underlying security (regardless of whether the assets/consideration are in the form of securities, cash or other property).
This treatment of changes in the underlying security is relatively simple to apply and matches the historical treatment of listed options in these circumstances. However, it does not account for the decrease in value of the option in situations where the volatility of the underlying security decreases. Volatility of the underlying security is one of the key inputs in valuing options, with higher volatilities generally increasing option value and lower volatilities decreasing it. Since the value of cash in practical terms does not change, cash has no volatility, which makes acquisitions paid for with cash (or similar events) of particular concern to convertible securities investors. These events may result in the transformation of the underlying security from common stock (which has some volatility) into cash (which has no volatility), and therefore reduce both the value of the option embedded in the convertible security and, by extension, the value of the convertible security. However, even if the new underlying security is also common stock (as in a stock for stock acquisition), a decrease in value will still occur if the volatility of the new common stock is less than that of the original common stock.
Convertible securities typically only provide limited protection against this decrease in value. The vast majority of convertible securities do so by requiring the issuer of the convertible securities to offer to repurchase the convertible securities from investors (an “investor put”) upon the occurrence of an event that changes the underlying security. The price that the convertible security is repurchased at typically equals its principal amount plus any accrued and unpaid interest. Investors thus typically may choose between putting the convertible securities for the principal amount, converting the convertible securities for parity (the value of the underlying securities into which the convertible securities is convertible) or continuing to hold the convertible securities. These choices all involve potential loss of value, particularly if the price of the convertible securities exceeds their principal amount. In this case, the value of the convertible securities prior to the effective date of the fundamental change exceeds both principal amount and parity, yet will decrease after the fundamental change if the volatility of the underlying securities decreases. Investors are thus protected only in situations where the value of the convertible securities does not exceed the greater of parity or the principal amount (typically when the price of the underlying securities remains below the conversion price).
Historically, investors have been willing to accept this limited protection against fundamental changes because the probability of specific issuers undergoing a fundamental change was viewed as difficult to determine exactly but generally low. When this has not been the case, such as with prospective issuers that have disclosed their discussions with potential acquirers or prospective issuers whom investors believe are likely acquisition targets, convertible securities investors have been less willing to purchase convertible securities issued by these entities or have demanded more favorable terms. In particular, investors may assess the value of the option embedded in the convertible security using a lower volatility assumption than they would otherwise to reflect the possibility that they will be unable to receive full value for the option upon a fundamental change. Since this affects the terms available to the issuing entities, it may decrease the attractiveness of issuing convertible securities and restrict these entities' flexibility in raising capital.
Prospective convertible security investors and underwriters of convertible securities are also disadvantaged if entities that otherwise might issue convertible securities do not choose to because of an inability to obtain attractive terms. This is especially the case to the extent that potential issuers are difficult to find.
A very few convertible securities have attempted to address this problem by increasing the repurchase price payable upon a fundamental change by an arbitrary amount which may be fixed or decline over time (e.g, 10% at issuance, declining by 0.50% semiannually until 100% is reached). However the market has not adopted this practice for a number of reasons, including that increasing the compensation arbitrarily does not satisfy investor concerns unless the amount is large enough to cover all contingencies that investors deem reasonably likely. Doing so may overcompensate investors in many scenarios and increases the potential price to the issuer, decreasing the willingness of the issuer to issue convertible securities. Moreover, the presence of an overly large compensating payment also may impair the willingness of potential acquirers to consummate a transaction with the issuer, which may further decrease the willingness of the issuer to issue convertible securities.
This problem has also been faced by the over-the-counter equity derivatives market, which has developed a practice of compensating option counterparties for the loss in value by terminating the option with a make-whole payment that preserves for the option counterparty the economic value of the transaction from the date of the fundamental change through its remaining life if the fundamental change had not occurred. The amount of the payment is determined based on quotations from market dealers using specified assumptions including historical volatility (typically over a two-year or 90 day period) and the price paid for the underlying securities in the fundamental change.
This approach works in the over-the-counter equity derivatives market but not in the convertible securities market largely due to fundamental differences in the nature of the two markets. Over-the-counter equity derivatives are typically sold in a privately negotiated transaction to a single counterparty that often is responsible for making all calculations under the contract and negotiates directly with the issuer. By contrast, convertible securities are virtually always sold to numerous investors in an offering through one or more underwriters or placement agents, with either the issuer or a trustee responsible for calculations. Because investors in convertible securities negotiate only indirectly with the issuer, they express their views mostly in terms of price (often as a yield and/or premium demanded for a specified price) assuming substantive provisions specifically described in the offering materials for the convertible securities (rather than negotiating the substantive provisions of the convertible securities directly). This process is further complicated by lack of standardization in the pricing models for convertible securities compared to the models used to price over-the-counter equity derivatives. As a result, convertible securities investors tend to strongly prefer certainty when the convertible securities are issued and reflect this preference in their pricing of a potential issuance.
In view of the foregoing, it may be desirable to develop a convertible security that adequately compensates convertible securities investors for the value of the option embedded in the convertible security if the issuer of the security underlying the convertible security undergoes a fundamental change.